Thursday, July 15, 2010

Recession Redux?

As all the econ-finance talk these days appears to center around the looming “double-dip” let’s take a closer look at two particularly sensitive and accurate leading indicators of our economic health to see if we can tease out the future trends.

The yield curve probability method is said to have a nearly perfect track record at predicting recessions some two to six quarters ahead with only one false positive, a period in 1967 that many economists, most notably the late Milton Friedman, considered to have been a credit crunch/mini-recession even though the NBER does not officially recognize it as such.

When the growth component of the WLI turns strongly negative (< -6) it generally means a notable slowdown or recession is in the offing.

So what are these two important indicators saying about our current economic situation?

As of the latest release of each measure, we are seeing a very unusual scenario of strongly mixed signals.

The yield curve spread indicator is indicating that the probability of recession is nearly zero while the ECRI leading index is showing a very pronounced pullback since a peak set in October 2009 with the growth component currently at a strongly negative level of -8.3.

Looking at the chart (click for full-screen super dynamic version) you can see that in the past, when both of these measures moved strongly in opposite directions, recession was a certainty.

Today though, the interpretation is not so simple.

Could the Feds work on both short (ZIRP) and long (MBS purchases) rates have rendered the yield curve method ineffective at the moment?

Is the WLI just over-correcting coming off of an epically pronounced bounce back in leading activity seen from the deeply recessed levels of March of 2009?

We will have to wait to see but clearly we are in a very unusual and tricky environment.